Financial Simulation Modeling in Excel

CHAPTER 3

Correlation

Once we understand the basics of random number generation, its applications in light of varying distributions, and basic examples of simulations, we should think more toward applications of these tools to finance. The most immediate applications relate to default, options, and commodity and interest rate projection. For each of these topics we have learned that there are more complex interactions at work than just generating a random number and assuming a certain distribution. Correlation between price movements or default status is perhaps the most important interaction that we need to be aware of. The financial crisis that began in 2007 has shown us the importance of estimating correlation correctly; one of the key failures in risk management and rating agency methodology going into the crisis was an underestimation of correlation within mortgage and structured debt default risk.